EMC - Some Thoughts On Sector M&A And What Shareholders Should Do

| About: VMware, Inc. (VMW)


In about three months, the long awaited merger between EMC and Dell will probably close.

The merger agreement will provide EMC shareholders with .11 of a tracking share called Class V that will mimic the economic performance of VMware as well as $24.05/share in cash.

VMW's shares, despite a positive reaction to last quarter's earnings release, have an extraordinarily low valuation.

Management guidance calls for a steady increase in bookings going through the balance of the year; the current consensus reflects no such thing.

Management says this is the year when its impressive arsenal of new products will surpass the steady decline of the company's historic mainstay of vSphere.

The short game - Do investors take a position in VMware or EMC in front of next week's earnings?

Once upon a time, EMC (NYSE:EMC) was a real growth company. No, it wasn't in the horseless carriage era, but it was in the era before Facebook (NASDAQ:FB). EMC was one of the original poster children of the first Internet bubble and was one of the leading companies of the day. At the height of the craziness, the shares traded at almost $100/share before collapsing to a low of $4.57 a mere two years later. And then, the long, slow climb back to current levels interrupted by the financial crisis.

And once upon a time, VMware (NYSE:VMW) was also a real growth company. As recently as 2014, VMware still grew 16% and somewhat further back in its history, it had been a hyper-growth company as desktop virtualization swept the IT business

The days of EMC being a growth company are long since passed, the days of Dell being a growth company are also long behind it, but none of that actually matters to those investors interested in buying what will be called the Class V tracking stock because it will essentially track the value of VMware's shares and nothing else. Overall, the new arrangement will give EMC's shareholders a 53% economic interest in VMware compared to the 81% interest they currently hold.

Simply put, if you are a current EMC shareholder and continue to hold your shares until the time of the merger, you will get $24.05 in cash and .111 shares of the new Class V stock that is tied to the value of VMware. At the moment, with VMware shares selling at $59, EMC shareholders will get a tracking stock that is notionally worth over $6.50/share, so they will get about $30.50 in value for shares that are currently selling for $27.51. Since it appears that there is little risk at this point that the merger between Dell and EMC will not be consummated; that seems a pretty good return for a straightforward arbitrage.

The tracking shares will inevitably sell at some modest discount to "real" VMW shares, I imagine, but it is still an attractive arbitrage, I believe. But the purpose of this article, now that I have described the essence of the transaction for current and potential EMC shareholders, relates for the outlook for VMW, as it is likely to be looking forward from the time the merger is consummated.

My initial article on VMW ran on April 22, 2016. Since that time, VMW's shares have appreciated by about 5%, almost exactly the same as the appreciation of the IGV software index over that time frame (The article was issued in the wake of a strong VMW earnings release and in the wake of that the shares rose 15% on the day of the release of the article).

There is some boiler plate in the filings to the effect that the architects and principals of the deal want to give current EMC shareholders the opportunity to participate in the synergies that the new shape of the combined company will engender. Well, I could tell my readers at this point that I am thin, rich and well preserved and that would have the same level of verisimilitude. The day that anyone in the P/E field actually operates with an eleemosynary agenda, lions and lambs will lie down together. The reason current EMC shareholders are getting equity in the new company was simply to construct a deal that would pass muster of the EMC shareholders and third-party fiduciaries.

The second thing to point out is that the success or failure of the combination of EMC and Dell will not be material, I believe, to the success of an investment in VMW. At one point, there was supposed to be some combined strategy in terms of amalgamating efforts that both EMC and VMware have with respect to the cloud. That kind of talk is over and VMW will run as an independent entity after the merger, the same as it has been run heretofore.

Overall, I believe that the merger has the potential to be a modest positive for the outlook for VMW. Clearly, the newly combined sales force, i.e., the sales force of Dell/EMC, is going to focus on selling hardware. But where it has to, it will be recommending VMware virtualization solutions. Heretofore, Dell had had a partnership with Citrix (NASDAQ:CTXS), and there had been rumors before the Dell/EMC merger was announced that Dell was going to buy CTXS. Somehow, Dell is going to have to try to persuade its joint customers with CTXS that they will be supported and loved all the while trying to pivot its newly combined sales force towards recommending VMW solutions. Not an easy thing to do, but as this article is about VMW and VMW only, the new focus that Dell will inevitably bring towards its VMware partner will have some positive impact for VMW's business - although how much is really impossible to determine at this point.

In addition, Dell has had a product in its software portfolio called vWorkspace. The product came to Dell as part of its acquisition of Quest Software back in 2012. Quest Software was not the best run of software vendors (and it served the least palatable food that I can recollect at its single analyst day event) and its divisional management structure more or less ensured that some of its offerings were orphan children. Dell effectively closed vWorkspace about a year ago.

Overall, Dell spent $2.4 billion to buy Quest in 2012, and it also spent a further $1.2 billion to buy SonicWALL and put those two companies together as Dell Software. Now that vWorkspace is gone, presumably, the new EMC/Dell will now push VMW's desktop solution rather than vWorkspace.

It is interesting that Dell was willing to sell what had been Dell Software for $2 billion after it had paid $3.6 billion for the pieces just a few years earlier. The transaction hasn't elicited the commentary that might have been anticipated as even in this day of risk-taking machismo, losing $1.6 billion or 44% of an investment in four years has to qualify for a position as one of the poorest commitments ever in the software business. Well, I suppose Autonomy was worse.

Personally, I am very dubious about the financial analysis that has driven the Dell/EMC combination. The business of making and selling spinning disc storage is in terminal decline. There is no combination that will change that fact. EMC has a decent portfolio in the SSD space, but the overall dollars that are going to be spent on storage will continue to decline as far as the eye can see and much of what is left of demand will be taken up by converged and particularly hyper-converged systems which essentially means that EMC is going to lose share of a shrinking market and has to face aggressive and nimble competitors. Overall, the impact that the cloud is having on the storage business is just in its early innings.

And the cloud has been and will continue to disrupt the overall demand for the kinds of servers that Dell sells. The huge 1 million server units + data centers that the major cloud providers are equipping simply do not and will not use brand name servers, and in many cases, the cloud companies use their internally developed or white box hardware. Putting two declining businesses together may make sense as an opportunity to rationalize costs. In fact, since the merger was agreed to last fall, the combined companies have started to shed staff, at least in the sales and marketing area. But how laying off a bunch of sales and marketing people is going to help grow sales, I really do not know! The May 8th publication of eWeek has an interesting article as to what is actually happening inside of both EMC and Dell and the real obstacles that the new organization will face; Michael Dell and his partners are very intelligent and able individuals - but they may have made their share of rookie mistakes and ignored some commonsense precepts in their goal to prove their machismo.

Fortunately, investors in VMW really do not have to concern themselves with the operating results of the new combination. I had little joy in covering EMC when I did, and I would have even less in covering this most unlovely of hermaphrodites!

Some significant valuation metrics!

VMW will announce its Q2 earnings in less than one week. I will take a shot later in this article of trying to handicap the results. I haven't had any informational advantage to be sure, but I can and will draw a few conclusions from the set-up for short-term trends.

At this writing, VMW has an enterprise value of about $19.9 billion (net of the $1.5 billion of notes payable due to EMC) and consensus sales estimates for this current year are $6.9 billion. So, that is an EV/S of a bit less than 2.9X, perhaps reasonable for a company with an estimated growth rate of 4% especially given its history of inconsistent results over the recent past. The company's P/E is estimated at less than 12X for the next 12 months and that is a pretty interesting metric.

Last year, the company reported operating cash flow of $1.9 billion and free cash flow of about $1.6 billion. Those results compared to operating cash flow of $2.18 billion and free cash flow of a bit greater than $1.3 billion in the prior year. The decline in operating cash flow was the result of a significant reduction in the growth of short-term liabilities - so the 2015 cash flow is of far "higher quality" than was the case in the prior year.

In Q1 2016, operating cash flow increased by a bit more than 5% to $720 mil. Free cash flow, driven by a significant drop in Cap Ex, grew by almost 18% to $679 million. Unlike many companies, VMW does forecast its cash flow and its free cash flow. Those forecasts are essentially consistent with Q1 results. The company is forecasting cash flow from operations for the full year to be $2.225 billion, up by 18.5%, and it is forecasting free cash flow to be $1.98 billion, up 27% from the prior year. Free cash flow of $1.98 billion would represent a yield of just about 10%, something almost unheard of in the IT investing world. These are really outlier valuations for a company that has reasonable growth and clearly are a product of investor and analyst concerns regarding management credibility. Even the valuation based on the current consensus forecasts for sales and EPS are a considerable bargain; if the company can complete its transition and become a growth business again, the shares are an extraordinary value.

The company had gross cash of $8.246 billion as of the end of Q1, although it has notes payable to its parent, EMC, of $1.5 billion. The notes have an annual interest rate of 1.75%. The notes are payable in three tranches between 2018 and 2022. About 75% of its cash is held offshore.

OK - What's the bad news? Why does VMW have such a low valuation?

VMW's shares for the most part have dramatically underperformed the market the past five years. The company's shares were $94.75 at the start of 2011 and were $106 as late as March 2014. A significant issue for investors has been one of growth. Growth had been in the mid-teens in 2014 and will fall to an estimated level of 4% for this year and 2017. Along the way to that growth rate, the company reported many quarters where results were below the prior consensus or earnings announcements during which estimates were cut. The culprit in that growth rate reduction has been the constant and significant decline in the company's legacy vSphere product. It was down 10% in Q1, but still represents 35% of total license bookings. Two years ago, it had been more than 50% of license bookings.

As the CEO, Patrick Gelsinger, put it on the call:

"We referred to this as the transition year, right? It's when the new product booking areas more than offset the compute license decline. Overall as we said it's about 10% (the decline in vSphere Q1 bookings) consistent with our modeling and expectation…And the new areas are growing very well and we gave a quite specific guidance on those areas and updates in Q1. So we remain quite committed to the acceleration of bookings as we go through the year…"

VMW's shares have a low valuation because investors do not believe the management forecast, and as far as that goes, neither do analysts. Further it is rumored that CEO Pat Gelsinger is to resign from VMW once the merger is completed, perhaps adding a further bit of uncertainty to the mix. I think most readers recognize just how difficult transitions can be. For readers not familiar, just look at the results of both Oracle (NYSE:ORCL) and IBM (NYSE:IBM) for the past few years and it becomes apparent just what a trick it is to pivot from the company's historical business in desktop virtualization to a host of newer solutions.

Investors are probably going to want to be convinced by actual, palpable numbers that the future being projected by Messer's Gelsinger and CFO Zane Rowe will be the future that actually turns out.

For a variety of reasons that I am going to detail in the next section, I think it is a good bet and one that is worth taking advantage of. Whether investors should avail themselves of the opportunity to obtain their interest in the economic future of VMW by just buying the shares today, in front of earnings, or whether they should buy EMC with the understanding that they may miss out on a move prior to the merger is a harder question and depends on several other factors.

OK, what is so hot about VMW these days that will pay us for taking the risk of a derailed transition?

I am not going to try to talk about all the product specifics that are part of the VMW strategy. There are just too many moving parts and almost certainly not all of them are going to succeed simultaneously.

One of the cornerstones of the VMW strategy is the private cloud. Without going through the set of offerings, the VM private cloud offers compatibility with vSphere on-premise solutions without the need to re-architect, application portability, flexible sizing and advanced networking. VMW is also offering what is called hyper-converged software. Hyper-converged software offers "breakthrough" performance, which has been sold to more than 3,500 customers in 21 months since the initial release of Virtual SAN, which is VMware's version of the technology.

Another important technology is VMware NSX, which is virtual networking and security. NSX enjoyed more than a 100% year-on-year increase in bookings. There have been 1,400 customers buying the software, and deployments have reached 350. Zane Rowe spoke about strong success in terms of VSAN license bookings, which is a component of hybrid-converged software offerings.

Hybrid Cloud, which is the technology direction of choice for the preponderance of large users at this point in time, led what is called vCloud Air Network to achieve 25% growth this past quarter.

There are a couple of caveats that need noting. VMware has what appears to this writer to be a winning strategy, and it has more than its share of green shoots in plain view. There are many, many other companies trying to copy pages from this playbook. Red Hat (NYSE:RHT) has a strategy somewhat similar to that of VMW; Citrix has been a rival in the virtualization field for many years now. There are many, many other companies large and small that are going to compete for positions in the hybrid cloud and in endpoints and almost everything else in between. How does VMW's software solution stack up against the hyper-converged solutions offered by Nutanix (NASDAQ:NTNX) or even the solutions offered by Hewlett Packard Enterprise (NYSE:HPE).

Another caveat is that VMware doesn't have a nice chart that makes it easy for analysts to draw lines about those products rising or falling. We have a little bit of quantification and a whole lot of obscurity. I have no real idea as to the current size of the company's VSAN bookings other than they are growing fast. At the moment, we are going to have to take the CEO's forecast that bookings will significantly accelerate in the balance of this year and that going into 2017, the growth parts of VMW are going to be large enough such that their growth will more than offset the continuing declines of vSphere and the other legacy products.

As opposed to these caveats, VMW enjoys many deep partnership arrangements with firms like AWS (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) Azure and IBM. Many observers including this writer believe that these partnerships will ultimately generate a significant level of very high margin for VMW.

So far, VMW's credibility within the analyst community is pretty low. A rating of 2.7 on the scale used by Thomson First Call is pretty awful. The median price target is $60, which doesn't leave much daylight when the shares are selling at $59.57. The last change in rating I've seen is that of Credit Agricole (OTCPK:CRARY) which dropped its rating to underperform. Seven buys and 24 holds plus the sell. Talk about a lack of credibility.

So what is the set-up and what does the quarter look like? And which one do I buy - EMC or VMware?

I like the set-up. The shares haven't even recovered from the post Brexit panic. They were $62 then (June 23rd) and $59 now. Many other IT names have done quite a bit better. There really is very little in the way of earnings expectations built into the present price. The IGV is up 1% over the same span.

The CEO, Pat Gelsinger, has put a line in the sand back in April in terms of talking about bookings rising steadily through the year significantly beyond the modest attainment of Q1. If you believe him, then it would be almost painfully foolish not to buy these very cheap shares. If this company can grow bookings more than revenues through the balance of the year, then the upside is significant. Talk about positive alpha - that would definitely be the case if bookings can rise steadily from first-quarter levels.

The company is doubtless going to start to talk about its expectations for 2017. And the math of the situation is not congruent with guiding to the current consensus of 4% growth. Even the top-line estimate for the September quarter, which calls for 3% growth, really can't stand if bookings are accelerating. And if bookings are accelerating, it seems reasonably certain to this writer that margins will grow as well, another potential not envisioned in the current analyst consensus. No, I certainly do not have an informational advantage, but based on all that, what has been said and how that translates into reported revenues and earnings - well, the odds certainly seem to favor a decent upside and by something more than would be obtained through shrinking the capitalization by share buybacks.

I started many words ago by considering the potentials of the EMC/Dell merger on VMware's shareholders. So, let me conclude by considering an appropriate strategy for investors considering making a commitment in terms of the economic future of VMware.

The two possibilities are simply buying VMware ahead of earnings or buying EMC ahead of earnings. With EMC, the investor gets a piece of paper that probably has a built in 8-9% share price appreciation. .11 shares of VMware is worth $6.60 + $24.05; equals more than $30, and EMC costs $27.59 to buy as of yesterday's close. I imagine the tracking stock will ultimately have a valuation marginally less than that of "normal" VMware shares (Class B). On the other hand, 80% of the package is cash, and cash is not going to appreciate. So the question boils down to a simple one - will VMware's prospective move in the wake of a successful quarter outweigh the current arbitrage + the appreciation that will come from calculating the value of VMW's anticipated distribution to current EMC shareholders.

At the end of the day, it all depends on just how optimistic and risk seeking the reader might be. If it were me - well, I own VMW shares at this time so that answers that question. But I think that it is close call and risk preferences will answer the question far more than analysis.

Summing up:

  1. The pending merger between EMC and Dell presents investors with a small menu of possible investment choices that center on the likely value of VMware's shares.
  2. There is, at the least, an attractive arbitrage potential in buying EMC, which is, to be sure, muted by the amount of cash in the transaction.
  3. VMW's valuation is at exceptionally modest levels.
  4. VMW's shares command disapprobation from the consensus of analysts.
  5. The outlook for VMW's business propounded by management during its last call is not reflected in the current valuation, or as far as it goes, in forward estimates.
  6. According to the management, this should be the year in which the decline in bookings from the company's historical desktop virtualization business is overtaken by bookings and revenue increase from a plethora of new technology, cloud-focused solutions.
  7. Even in the very short term, post Brexit, in fact, the shares have reflected poor investor sentiment.
  8. This would be a quarter in which to validate the management thesis regarding increasing bookings and for some parameters regarding the outlook for 2017.

There are, as analyzed above, two ways of playing the VMW investment opportunity depending on risk preferences and some assumptions. Either way should produce positive alpha for investors.

Disclosure: I am/we are long VMW.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.